Ukraine: What Went Wrong and How to Fix It Preview Chapter 9

9 Achieving Financial Stability and Sustainability One of the main objectives of the tax reform is to eliminate the shadow economy. —Ihor Bilous, head of the State Fiscal Service1 Ukraine’s1fiscal policy is the nexus of everything that is wrong with the Ukrai- nian state and economy. The government collects too much money from the economy, but it spends far more. It uses the funds not only inefficiently but corruptly, redistributing incomes to the criminal and powerful, while depressing economic growth. The tax administration is a major cause of corruption and poor business climate. Ukraine’s fiscal system does not fulfill any of its basic aims and needs thorough reform. In 2014, Ukraine was in a rampant financial crisis of falling output, caus- ing a rising budget deficit, leading to a fast depreciation of the currency, which in turn boosted inflation. As a consequence, half the banking system was col- lapsing and public debt rose ruthlessly. The underlying reason was years of financial mismanagement, but since April Russian military aggression has caused most of the output fall, rendering the financial crisis acute. It has to be dealt with swiftly and firmly. Ukraine’s public expenditures have persistently been much too high by any standard, depressing economic growth. A large share of the public expenditures consists of subsidies to the wealthiest or outright corrupt. The excessive expenditures cannot be financed, resulting in steady budget deficits and a substantial public debt. The public expenditures must be cut significantly. In the next few years the budget needs to be brought to balance if Ukraine is to be financially sustainable, and the public debt should gradually be reduced through small budget surpluses in the medium term. The total tax revenues are surprisingly stable and have persistently been 1. “Ihor Bilous: Ne mogu skazat’, chto sokrashchu vdvoye kolichestvo nalogovikov” [“Ihor Bilous: I cannot say that I will cut the number of taxmen by half”], Zerkalo nedeli, August 29, 2014. 157 © Peterson Institute for International Economics | www.piie.com high. The tax burden and the number of taxes should be reduced as expenditures are slashed. Taxes on labor, especially the payroll tax, are far too high and should be cut to reduce the shadow economy. Tax rates should be low and flat. The Ukrainian tax administration is not only cumbersome but also lawless. The tax system should be simplified, the tax police abolished, and taxation decrimi- nalized. As political and state powers are being decentralized, so should the management of both revenues and expenditures. The banking system is in shambles and the front of the financial crisis. Many failing banks should be closed down because the government can no longer afford much recapitalization. In the current crisis, Ukraine can hardly avoid default. The public debt is not very large by international comparisons, but it is skyrocketing. The best approach seems to be an agreed prolongation of the existing debt in the frame- work of a new International Monetary Fund (IMF) program. The fiscal reforms should aim not only at resolving the current economic crisis but also at building the institutional foundation for sustainable long- term growth. This involves a major rethinking of the role of the state in the economy and the appropriate form and degree of state regulation. Rampant Financial Crisis By the summer of 2014 Ukraine had fallen victim to a serious financial crisis. According to the IMF, the 2014 budget deficit was set to reach 10.1 percent of GDP, which was based on the assumption that output would decline by 6.5 percent (IMF 2014d, 39).2 The main driver of the financial crisis was the contraction of output, which largely depended on the intensity of the warfare. In the first quarter of 2014, before Russian aggression hit the economy, Ukrainian GDP contracted by only 1.1 percent. In the second quarter, as Russian military aggression started in the south and east, GDP fell by 4.6 percent. In the third quarter, GDP declined by 5.1 percent year over year,3 and in the fourth by 15.2 percent. These numbers reflect two contradictory trends. Ukraine’s annualized industrial production plunged because of fighting in Donbas—at most in Au- gust by 21.4 percent and 10.7 percent for 2014 as a whole. The war damages seem to have peaked in the third quarter, and the fourth quarter saw some recovery. The decline was driven by the fall in coal production by as much as 66 percent in October in annualized terms and steel production by one-third. At the same time, Ukraine’s agriculture was growing, compensating somewhat for the industrial decline. The second driver was the depreciation of the exchange rate. The hryvnia lost half its dollar value in a year, falling from 8 hryvnia per US dollar in No- vember 2013, when Euromaidan started, to 16 hryvnia per dollar in mid-No- vember 2014. In early 2014, the National Bank of Ukraine (NBU) had no choice 2. “Ukraine Needs More Financial Help, IIF Says,” Reuters, September 23, 2014. 3. UniCredit Bank, “Banking Flash,” Kyiv, November 3, 2014. 158 UKRAINE: WHAT WENT WRONG AND HOW TO FIX IT © Peterson Institute for International Economics | www.piie.com but to let the exchange rate float. In September–October, the NBU maintained an actual peg of 12.95 hryvnia per dollar. In early November that peg collapsed as international reserves fell below the critical level of $12.6 billion. At the end of 2014, reserves had shrunk to $7.5 billion. In spite of severe currency regula- tions, the economy appeared to have entered a devaluation-inflation cycle, as year-end inflation reached 25 percent. Inflation could easily rise to triple digits within a year as happened in Belarus in 2011. An advantage of the sharp depreciation of the hryvnia is that Ukraine’s sizable current account deficit turned into a surplus in 2014, as imports fell far more than exports. Banks have incurred large losses because of the depreciation of the hryvnia. The government has been caught in a hopeless conundrum. Only the Ukrainian government can bail out the banks. Ukraine has been shut out of the international debt market for two years. Since the government had no financing, it had no choice but to sell bonds to the NBU and related state banks financed by the NBU, which together hold 60 percent of Ukraine’s public debt. Any announcement of recapitalization of the banks leads to new depreciation. After the fall of Yanukovych, the new Yatsenyuk government quickly ap- pealed to the IMF, and as early as March 2014 the IMF concluded a two-year Stand-By Arrangement with total international financial support of $33 billion for two years, of which the IMF itself would contribute $17 billion. The rest of the funding would come from the World Bank, the European Union, the European Investment Bank (EIB), the European Bank for Reconstruction and Development (EBRD), and various bilateral creditors. The program was based on benign assumptions of no further Russian military aggression but rightly emphasized the geopolitical risks. With increased war damage, preconditions changed substantially, and the program had become unrealistic by April 2014. All indicators turned out far worse than the IMF expected. Former IMF official Susan Schadler (2014, 7) noted with understatement that the “report gives the impression that IMF staff and management find the program scenario as skewed toward optimism as markets do.” This IMF program was not credible and had to be redone. In December 2014, Ukraine’s financial situation was desperate but not hopeless. Without a substantial change in the country’s economic policies, a financial meltdown within three months or so appeared imminent (see chapter 2). A government had been formed and it had adopted a radical program for fiscal adjustment and structural reform. Even so, Ukraine needed substantial new financing, not only credits to replenish its international reserves but also grants to cover the substantial war damage, as argued in chapter 3. Cut Public Expenditures In the 1950s and 1960s, the dominant Western view was that the level of public expenditures did not matter as long as a country had its budget deficit under control. The United States had a marginal income tax exceeding 90 percent (Tanzi 2011). Even today, the IMF tends to be neutral on this issue. Axiomati- ACHIEVING FINANCIAL STABILITY AND SUSTAINABILITY 159 © Peterson Institute for International Economics | www.piie.com cally, the European Union considers the EU average ideal, without considering its economic effects. Yet, multiple econometric studies show that low public expenditures are better than large, but of course they must be properly financed so that the public deficit does not become excessive (Barro and Sala-i-Martín 2004). The post- communist country that has persisted with high public expenditures, large budget deficits, and big public debt is Hungary—and Ukraine comes close to it. Both have public expenditures over 50 percent of GDP. While Estonia more than doubled its GDP from 1990 to 2012 in real terms, Hungary’s grew by a miserable 24 percent (World Bank 2014a). The cause in Hungary as in Ukraine was that politicians refused to heed the insights of sensible economists who warned about its “premature social welfare society” (Kornai 1992, Bokros 2014). Ukraine is doing even worse, with lower GDP today than in 1990, according to the World Bank (2014a). Moreover, the less developed and the more corrupt the state is, the less public redistribution of revenue is morally justi- fied, because it is likely to be done more inefficiently than in an honest and well-developed state (Milanovic 1998).

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